Investment banks are confusing organisations to understand at first, especially in light of the fact that a plethora of acronyms are used to describe everything from divisions and geographies to financial products and markets. The easiest way to familiarise yourself with the relevant jargon is to spend time inside investment banks and talk to those who spend most of their days (and many nights!) working in them. This overview is aimed at those looking to gain a basic insight into the workings of an investment bank. It should enable the reader to present him or herself with the necessary confidence and understanding of the industry to succeed during interviews and internships. Remember that the fundamental role of an investment bank is to connect organisations seeking capital (money) with investors looking to invest funds in order to grow their own capital.
Investors seek a return on their investment that at least matches the rate of inflation. They usually invest in companies or securities if the potential return on investment exceeds the return that could be achieved via other means (such as saving in a bank account or purchasing government bonds). In this context, investors are typically high net-worth individuals, private equity firms or corporate entities referred to as investment funds. The latter includes the companies to which we pay our pension contributions (pension funds) and insurance premiums (insurance companies), mutual funds and sovereign wealth funds.
Organisations Requiring Capital
Companies require capital to acquire other firms and assets, invest in new ventures, expand into new regions and finance operations. Governments require capital to facilitate investment or repay older debt that has fallen due.
intermediaries between investors and organisations requiring capital. The way in which the financial markets operate is often very complex, but banks are essentially the conduits of capital. Without the service of wholesale, investment or merchant banks, companies would find it far more difficult to raise capital (and thus expand and invest) and investors would struggle to access investment opportunities that could grow their capital.
Institutional Investors / Investment Funds: institutions with specialist knowledge that trade (buy and sell) securities (such as shares, bonds or derivatives) in large quantities, usually on behalf of others. Examples include: asset managers, mutual funds, hedge funds, pension funds and insurance companies.
Pension Funds & Insurance Companies: pension funds invest the pension contributions made by employees/employers in order to generate a return that will enable them to provide retirement income for employees when they reach the end of their working lives. Insurance companies invest insurance premiums in order to make a profit and to ensure enough capital is generated to cover insurance claims in the future.
Hedge Funds: these are sophisticated investment firms that aim to generate high returns from investments using advanced investment strategies. These firms typically have short-term investment horizons and invest capital that has been borrowed from investment banks. Hedge funds try to make money regardless of whether the market moves up or down.
Private Equity Firms: these aggregate funds from institutional investors and private individuals. They aim to purchase mature businesses with established strategies and reliable cash flows, at low prices, using large quantities of debt. Through improving operational efficiency (e.g. cutting costs) and using financial engineering techniques (e.g. paying down (paying off) debt using operating cash flows), private equity firms aim to increase the value of companies in which they have invested. Typically, they look to then sell on the companies for a profit after 3-5 years of ownership and improvements.
Venture Capital Firms: these also aggregate funds from institutional investors and private individuals. They invest in companies at a very early stage (sometimes before companies have generated any profit) and often use industry experts to help grow the business.
Sovereign Wealth Funds: state-owned investment funds that invest for the benefit of a country’s economy and citizens.
Securities: financing or investment instruments such as bonds and shares.
Cost Of Capital: the cost for an organisation to raise and sustain capital. For capital sourced through borrowing (debt capital), this is the cost of the interest payments a borrower must make to a lender. For equity investments (e.g. share purchases), this is the reward demanded by investors to compensate for the risks relating to their equity investment. Potential rewards include capital gains (which occur when shares are sold for more than they were purchased) and dividend payments. Potential risks include the fact that share prices may fall and that there is no legal obligation for companies to pay dividends to shareholders. The cost of capital can vary depending on current market conditions and an organisation’s financial performance, maturity and creditworthiness (including its track record and the nature of any previous relationships with investors). Organisations will usually be willing to pay a reasonable price for capital, based upon the assumption that they will be able to generate financial returns (from investing that capital) that exceed the amount paid to investors for their capital (the cost of capital).
Premium: paying a premium means paying an amount that exceeds the market value of a product or company. Premiums can be offered by potential purchasers (or borrowers) to persuade sellers (or lenders) to engage in transactions. Buyers will offer premiums in the belief that they will be able to extract additional value from the target company post-acquisition, either because it is under-valued, underperforming or unable to operate as efficiently as it could if controlled by the buyer.